Between teaching, working with staff, tutoring, and building a freelance career

Wednesday, August 22, 2007

Do Insider Trading and Short Selling Provide Useful Information?

The answer (according to University of Michigan professors NajatSeyhun and AmiyatoshPurnananadam) seems to be "yes".

In a new study that just hit the SSRN, they find that combining "standardized" short selling and insider trading provides better information about future returns than either does separately. They create their standardized measures by first calculating average historical levels of insider trading (purchases scaled by total shares outstanding) and then dividing differences from the average by historical standard deviations in insider trading and short interest. They find a number of interesting patterns with these measures:

The two measures (standardized insider purchasing and standardized short interest) are only very weakly correlated. This means that the two measures aren't capturing the same information. So, there are potential gains to suing both in combination.

They argue that using patterns in insider purchasing, they can identify "informed" short selling. In other words, when insider trades are in the same direction as short sales, short selling is most likely to be driven by informed traders. In other words, when standardized insider purchases are low (i.e. insiders have bad news) and standardized short interest is high (i.e. short sellers have bad news), subsequent stock returns are likely to be low (and the opposite for high insider purchases and low short interest).

When they form hedge portfolios that are long the "good" firms (high insider purchases and low short interest) and short the "bad" firms (low insider purchases and high short interest), they get obtain risk adjusted returns (based on 4-factor model) of 0.88% to 1.22% per month.

So in short (no pun intended), their study finds pretty credible evidence that short selling and insider trading could potentially be combined into a profitable trading strategy.